If you have some surplus cash leaving it in your bank savings account may not be your best bet. If you want to beat inflation and see the purchasing power of your extra cash grow, liquid funds are a much more efficient option over your trusted savings account.

What are Liquid Funds?

Liquid funds are high liquidity open-ended income schemes that invest in debt and money market instruments such as government securities, treasury bills and call money among others. These instruments have a maximum maturity period of 91 days and are considered safe because they mitigate interest rate volatility risk.

The credit risk or the risk of default too is low on liquid funds.This is because investments are made by fund managers after careful evaluation of factors such as the financial strength of the credit and quality of management.

Liquid funds are also unique as compared to other funds in the debt category with regards to the applicability of Net Asset Value or NAV. The NAV of liquid funds is calculated for 365 days as compared to other debt funds where the NAV is calculated only for business days. For all transactions in liquid funds, irrespective of the value of investment, the units are allotted as per the previous day’s NAV if the application is received before the cut-off time (i.e. 2pm).

The liquidity factor is most attractive for investors in such funds as the redemption payouts are credited to the bank account on the next working day. Liquid funds are therefore capable of generating a stable income while providing high liquidity to one’s portfolio.

Pros and cons of investing in liquid funds

Pros

Taxation benefits

The Union Budget of FY2014-15 revised the manner in which dividend distribution tax (DDT) on debt funds is calculated. Though the DDT rate remains the same at 28.32% it is now calculated on the gross amount as opposed to the net amount being distributed. So if a retail investor is not too keen on cash flows periodically, but is interested in a lower tax outgo, he can use liquid funds to his benefit. This is true of investors who fall in the highest tax bracket who will still end up paying lesser tax on liquid funds (28.32%) as compared to a bank fixed deposit (30.90%). Those in the lower tax brackets can opt for the growth option of liquid funds as they can benefit by paying a lesser tax at 20% as they avail of indexation benefits. Besides, dividends from liquid funds are tax free in the hands of investors. This makes them more attractive than fixed deposits. If an investor opts for the dividend reinvestment option in liquid funds, his dividends will be considered as fresh investments and thus the capital gains tax he/she has to pay for the short-term will be minimal.

Liquid funds have scored over their nearest counterpart, the savings account in the past five years. While savings bank deposits have offered pre-tax returns of 4-6% in this time frame, liquid funds have delivered 7-9% returns annually over this period.

No lock-in period

Withdrawals processedin 24 hours

No exit load

Cons

Liquid funds however lose out to savings accounts on the safety aspect. Liquid funds do not offer the safety of a savings account, where investments of upto ₹1 lakh are covered under deposit insurance. Although the chances of things going awry with liquid funds is minimal, given their low maturity and high liquidity feature, there is no guarantee of the capital you invest here.

When should you consider liquid funds?

If a sizeable sum of money is lying idle in your savings bank account, you are better off investing it in a liquid fund.

Consider this example:

You have to pay ₹50,000 for your daughter’s school fee in the month of June and in the month of July you have an insurance premium of ₹30,000 to pay. This total sum of ₹80,000 is lying idle in your account in April and you would like it to invest it somewhere for a small time frame.
Stock markets or equity funds are too risky a proposition for these important payouts whereas bank fixed deposits will lock in your money and the returns will be low. You can therefore consider liquid funds such that you can redeem your units in 24 hours and earn a little more than what you would have earned in a bank fixed deposit. Moreover, the tax liability remains the same as it would have been in an FD or your savings account. Liquid funds are therefore your best bet for these three months.

Conclusion

Liquid funds are ideal when you want to invest your spare cash for a small time frame and earn superior returns on them. If you are in the highest tax bracket, liquid funds can prove to be more tax efficient as they add up to higher post tax returns. Therefore liquid funds can be an ideal alternative to short-term fixed deposits.